Mutual funds gained popularity among the investing public in the 1980s and 1990s. They began as a way for large institutional investors to pool their money for a common purpose, and spread the risk of losses, inside a mutually owned fund, hence the name mutual fund. Now, mutual funds are a staple of most everyday Americans’ nest eggs and is considered a good way to diversify your retirement plan.
What you may not be aware of is that there are in fact various types of mutual funds. The two main ones are open-end and closed-end. Understanding the differences between them can help you broaden and strengthen your investment portfolio asset allocation based on your investment risk tolerance.
What Are Open-End Mutual Funds?
When most people think of a “mutual fund,” what they are thinking of is an open-end mutual fund. This type of mutual fund does not have restrictions on the amount of shares that the fund can issue to current and new investors. Therefore, if demand for shares of an open-end mutual fund increases, the mutual fund and the company that runs it will continue to issue new shares no matter how many investors there are. Open-end mutual funds can also buy back shares of the fund when investors wish to sell. The mutual fund itself is the market maker and ensures that there are buyers and sellers when that function is needed. It is valued based on net asset value, or NAV, which is the total market value of its underlying assets. As a result of these characteristics, open-end mutual funds allow investors a lot of flexibility.
What Are Closed-End Mutual Funds?
Whereas an open-end mutual fund is constantly adding and subtracting to its total shares outstanding, a closed-end mutual fund does not engage in the traditional adding and subtracting of additional shares. Instead, a closed-end mutual fund trades through a stock exchange such as the New York Stock Exchange (NYSE) and has a fixed number of shares that are available to the market. For example, if one million shares are issued during an initial public offering (IPO) of a fund, then that amount will be the set amount to be traded back and forth through intermediaries.
4 Things to Consider When Investing in Mutual Funds
1. Commission Fees
Since closed-end funds are traded exactly like stock shares, an investor will pay a brokerage commission every time he or she buys and sells shares in a closed-end mutual fund. This makes closed-end mutual funds unappealing for small investors who like to use dollar-cost averaging or systematic investing every month to build a position in a mutual fund. Because of the ability to quickly trade in and out of a closed-ended mutual fund, these types of investments are often used more by the short-term investor who may jump in and out of a position as the price moves throughout the day. These types of mutual funds also qualify to be traded using limit orders and stop orders, unlike open-end mutual funds. Open-end mutual funds were designed with the long-term investor in mind. Do keep in mind that there are still investment management fees you need to pay.
2. Discounted Pricing
Prices of closed-end mutual funds are not pegged to the net asset value (NAV) like open-end mutual funds. Instead, they are priced by the supply and demand for the finite number of shares in the marketplace. One benefit of this type of pricing is that a closed-end mutual fund can trade at a share price lower than its underlying assets. When shares trade at a low price, the discount can be quite enticing to potential investors looking for an extra boost in capital appreciation.
As with any type of investment, there are risks associated with these funds. The price of either a closed-end or open-end mutual fund can fluctuate and both are subject to sudden inflows or redemptions. Closed-end mutual funds find themselves at the mercy of volatility even more so than a typical open-ended one because of their share structure and inability to issue new shares. One of the disadvantages of having a set number of shares is that there may not be enough sellers to satisfy the demand of buyers, or vice versa, which can make the price swing more than the value of the stocks that it owns. In many closed-end funds, the volume traded is very low which exacerbates the price fluctuations, while new buyers are found to purchase the shares of a large redemption.
4. When Prices Are Set
As mentioned before, closed-end mutual funds continuously trade on the open stock market throughout the day. The prices of these funds are continually shifting to meet supply and demand. Conversely, open-end mutual funds recalculate their share price once per day when the stock market closes and the value of its underlying stock assets are recalculated. Therefore, investors can buy and sell their shares based on the price of the open-ended mutual fund at the close of the previous business day, when the NAV was recalculated.
Which Mutual Fund Is Right for You?
Both open-end and closed-end mutual funds are great investing options in their own right. They each serve separate purposes for long-term and short-term investors (i.e. beta vs. alpha investing strategies and styles)
If you are a long-term investor who has several years or even decades until you need the money you are investing back, then traditional open-end mutual funds are most likely the right choice for you. Open-end mutual fund are the perfect choice for the buy and hold investor and for the investor who is looking to use dollar-cost averaging in order to build a position in a mutual fund over a long period of time.
A closed-end mutual fund is a great investment choice for an investor who has a large amount of money to invest or who wants to invest over a short period of time. Because investors must pay commissions on every purchase, using closed-end mutual funds especially with a large investment utilizing the discounted NAV price can be a very worthwhile investment.
Investors should take the time to make careful consideration to ensure that they are investing in the correct type of mutual fund for their own financial situation and goals.
Are you invested in any mutual funds? What are you preferences – open or closed-end?